Research

Abstract: We examine the inclusion of debt performance metrics (DPMs) into executive compensation contracts as a strategic response to the agency costs of debt. Using a manually collected dataset, we find that approximately 19% of US publicly traded firms incorporated DPMs in their compensation contracts between 2007 and 2020. The likelihood of including DPMs increases after creditors' monitoring incentives increase due to credit quality deterioration or debt maturity pressure. To facilitate causal inferences, we use the exogenous default of lenders' other clients and observe that focal companies are more likely to include DPMs in compensation contracts when lenders perceive an increased likelihood of future insolvency. We document that shareholders incorporate more non-debt metrics in their incentive programs in response to DPM inclusion, and they request the inclusion of DPM before corporate borrowing. Our results indicate that firms with DPMs in compensation contracts reduce future R&D intensity and SG&A expenses. Our study highlights the importance of debt-related factors in executive compensation and contributes to understanding the agency costs of debt.